I think the Financial Times must be a Grant's subscriber.
Hedge funds home in on housing
By Saskia Scholtes and Michael Mackenzie in New York
Published: September 27 2006 21:24 | Last updated: September 27 2006 21:24
Growing numbers of hedge funds have placed bets on a slump in the US housing sector in recent weeks, weakening a key index tied to the performance of subprime mortgages, according to dealers.
“We’ve seen macro hedge funds become increasingly negative on the US housing market. It seems to be the one trade that they can all agree on,” said Jack McCleary, head of US asset-backed securities trading at UBS.
As a result, the ABX index – which represents a basket of credit default swaps on subprime mortgages and home equity loans – has declined significantly. The lowest-rated tranche of the index has been most affected, widening by around 50 basis points over the last two weeks.
CDS on asset-backed securities such as home equity loans provide a type of insurance against the default of a specific security. The buyer of insurance pays a quarterly premium in exchange for guaranteed payments if the underlying security experiences losses.
Hedge funds have thus bought insurance on the ABX or on individual securities in the index to place themselves on the winning side of a housing downturn.
However, the trade only begins to pay out if there are losses on the underlying securities – a phenomenon that has not yet begun to play out even in the riskiest subprime mortgages.
Mustafa Chowdhury, head of US rates research at Deutsche Bank warns that the bet could cost hedge funds a pretty penny before the market really starts to turn. “Shorting the ABX looks a little like a race between the cost of the trade and widespread house price declines,” said Mr Chowdhury.
Mr McCleary at UBS explains because many macro hedge funds have struggled to make money in a flat yield curve environment, “they view this as a very cheap option to buy on what they think is a relatively certain decline in US home prices”.
With almost every passing data point, signs of a slowdown in US housing have become increasingly ominous, suggesting that losses on mortgage pools may not be far off.
Annual prices for existing homes fell for the first time in a decade in August, according to the latest data, while aggressive underwriting and weak mortgage lending standards have flooded the market with increasingly risky pools of mortgage debt. Deutsche Bank warns that subprime residential mortgage-backed securities issued in the first half of 2006 could “potentially be one of the weakest vintages”.
Until recently, the mortgage markets have remained largely unperturbed, since weakness in housing has not yet translated into rising defaults and mortgage delinquencies.
Scott Kirby, head of structured products at fund manager RiverSource Investments, explains that, contrary to previous housing downturns, the market has also been buoyed by the popularity of collateralised debt obligations – bonds backed by pools of other bonds. These portfolios can include various loans but many are backed by consumer debts, of which housing-related loans are the most common.
“CDOs and other structures backed by sub-prime mortgages have provided a very strong technical support for the market. We didn’t have this dynamic 10 years ago and it has yet to be tested,” said Mr Kirby.
Despite the increasingly gloomy outlook for housing, the CDO machine has continued to buy mortgages because, as Mr Chowdhury at Deutsche Bank explains, “the flat yield curve means there is no spread in most other markets”.
But the market is now preparing for a deeper housing downturn. Mr Kirby at RiverSource Investments said: “A period of flat to negative home price appreciation will warrant watching closely as it places subprime and home equity borrowers most at risk of defaulting.”
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